Single Market Factor №2 Largest Overnight Gap

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When a futures market starts trading on a given day it is very rare that trading opens exactly at the price at which it closed it the day before. Usually the opening range of prices is above or below the prior day's close. This is commonly referred to as the "opening gap." Generally opening gaps are not large. However, every once in a while something happens between the time the market closes one day and opens the next which causes prices to gap sharply higher or lower on the opening. It is extremely important to understand the implications of such events. If a market gaps sharply lower one day it means that every trader who was long as of the close the prior day suffers a big hit immediately upon the start of trading. It is important to be aware that these gaps can occur and of the potential magnitude of these moves. Unfortunately, the common response to such a possibility is "that probably won't happen to me." This is not the proper response. The proper response that the winning trader will consider is "what if this does happen to me?" Asking and answering this question allows you to be prepared for just such an event.

Immediately prior to the outset of the Gulf War, the common thinking was that if a messy war in the Middle East were to unfold, the price of Crude Oil would skyrocket based on great uncertainties regarding the supply of oil. On January 16, 1991, Crude Oil, traded on the New York Mercantile Exchange (NYMEX), closed at $30.29 a barrel. That night the U.S. and its allied forces unleashed a furious and highly successful air raid on Iraq which immediately raised the potential for a quick victory. The next morning the first trade for Crude Oil took place at $22.79 a barrel. This equates to a gap opening of $7.50 a barrel, or $7,500 a contract. Consider what happened in an instant when Crude Oil opened for trading that day.

Everyone who was short Crude Oil at the previous close was instantly $7,500 per contract richer. Everyone who was long Crude Oil at the previous close was instantly $7,500 per contract poorer.

Will Crude Oil ever experience another gap that big? There is no way to predict the answer to this question. It may or may not some day experience an even bigger gap. What is important is to realize that if such a move happened once it can certainly happen again. So you must prepare yourself for this possibility. If you are long a Crude Oil contract at today's close and it opens $7.50 a barrel lower tomorrow, how will you react? And more importantly, will you survive?

Table 2-1 displays the largest overnight gap in dollars for a number of futures markets. Some markets such as grains and interest rates have daily limits. For instance, a limit move for T-Bonds is 3 full points, or $3,000 per contract. So if T-bonds closed one day at 100, on the next trading day they could trade as low as 97 and/or as high as 103, but not beyond these two prices. A daily limit move for Soybeans is $0.30 or $1,500. However, if Soybeans have three limit moves in a row in the same direction then the limit for the next day expands to $0.45 or $2,250 per contract. The good news regarding markets with daily price limits is that you can only lose so much money in a single day. The bad news is that you may be "locked in" to position with no way to exit if that market moves lock limit against you. Also, in the worst case scenario a limit move one day can beget another limit move the next day. This can cause losses far in excess of what you might have expected.

Other markets have no daily limits. The bad news regarding trading markets with no limits is that there is no way to know if and when the previous records shown in Table 2-1 might be exceeded. Nor is there any way to predict if you will be on the right or wrong side of such a move. This is why it is important to acknowledge that such a move is possible, that you could be on the wrong side of that move and to appreciate the negative effect it could have on your trading account.

The purpose of carefully examining the largest overnight gaps shown in Table 2-1 is twofold. The first is to inject a sobering dose of reality into anyone who thinks that trading futures is going to generate easy profits. The second is to get a handle on just how much capital you realistically need in order to trade a given market.